A Framework for Developing Your Financial Strategyinvestors’ expectations from growth, margins,...

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LEK.COM L.E.K. Consulting Executive Insights EXECUTIVE INSIGHTS VOLUME VI, ISSUE 3 A Framework for Developing Your Financial Strategy A Framework for Developing Your Financial Strategy was written by François Mallette,Vice President in L.E.K.’s Boston office. Please contact L.E.K. at [email protected] for additional information. Financial strategy – the set of policies that determines capitalization,the sourcing of funds and distributions to shareholders – has a significant impact on a company’s ability to invest for value creation, provides important signals to the investment community, and can capture for shareholders the value created in the company. Yet financial strategy frequently receives limited critical review by management. While key components of operations are frequently scrutinized and updated, our experience reveals that, despite its impact on value, many organizations do not have an overarching framework for systematically assessing their financial strategy to ensure it is internally consistent and aligned with the operations of the company. As a result of a number of converging factors, however, we have seen a rise in demand by boards of directors and management teams to reassess their financial strategies. To illustrate the issues involved and a framework for establishing an aligned financial strategy, we examine how the senior management team and the board of directors of “Willow, Inc.,” 1 worked with L.E.K. Consulting to realign its financial strategy to address the company’s growing balance of cash. Willow, Inc. – A Case Study Willow is a mid-cap industrial services company that operates in an industry where it and its three top competitors collectively have 70% market share. This leaves very few significant acquisition targets in an industry that was once rife with consolidation opportunities. Over the previous 24 months and just prior to beginning its work with L.E.K., Willow had focused on extracting operating efficiencies from its past acquisitions and was at the point where significant, steady cash flows were being generated. Revenues, however, were expected to grow only in line with the GDP. The company’s expressed strategy was to remain focused on its core business in the domestic market (i.e., no growth was planned from vertical integration or acquiring businesses outside its core industry). L.E.K. was engaged to help Willow’s management develop a customized financial strategy that best suited the organization’s circumstances and to create a framework for the board to judge both short-term financial tactics and the evolution of the strategy over time.

Transcript of A Framework for Developing Your Financial Strategyinvestors’ expectations from growth, margins,...

Page 1: A Framework for Developing Your Financial Strategyinvestors’ expectations from growth, margins, investments and other financial measures, in order to define the options Willow could

L E K . C O ML.E.K. Consulting Executive Insights

EXECUTIVE INSIGHTS VOLUME VI, ISSUE 3

A Framework for Developing Your Financial Strategy

A Framework for Developing Your Financial Strategy was written by François Mallette, Vice President in L.E.K.’s Boston office. Please contact L.E.K. at [email protected] for additional information.

Financial strategy – the set of policies

that determines capitalization,the

sourcing of funds and distributions to

shareholders – has a significant impact

on a company’s ability to invest for value

creation, provides important signals to the

investment community, and can capture

for shareholders the value created in the

company.

Yet financial strategy frequently receives

limited critical review by management.

While key components of operations

are frequently scrutinized and updated,

our experience reveals that, despite its

impact on value, many organizations do

not have an overarching framework for

systematically assessing their financial

strategy to ensure it is internally

consistent and aligned with the

operations of the company. As a result of

a number of converging factors, however,

we have seen a rise in demand by boards

of directors and management teams to

reassess their financial strategies.

To illustrate the issues involved and a

framework for establishing an aligned

financial strategy, we examine how the

senior management team and the

board of directors of “Willow, Inc.,”1

worked with L.E.K. Consulting to realign

its financial strategy to address the

company’s growing balance of cash.

Willow, Inc. – A Case Study

Willow is a mid-cap industrial services

company that operates in an industry

where it and its three top competitors

collectively have 70% market share.

This leaves very few significant acquisition

targets in an industry that was once

rife with consolidation opportunities.

Over the previous 24 months and just

prior to beginning its work with L.E.K.,

Willow had focused on extracting

operating efficiencies from its past

acquisitions and was at the point where

significant, steady cash flows were being

generated. Revenues, however, were

expected to grow only in line with the

GDP. The company’s expressed strategy

was to remain focused on its core business

in the domestic market (i.e., no growth

was planned from vertical integration

or acquiring businesses outside its core

industry).

L.E.K. was engaged to help Willow’s

management develop a customized

financial strategy that best suited the

organization’s circumstances and to create

a framework for the board to judge both

short-term financial tactics and the

evolution of the strategy over time.

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To achieve these goals, the following

process was used:

Step 1: Establish an appropriate

capital structure, after which a

determination would be made of the

magnitude of its cash surplus. It was

apparent that Willow was a victim of its

success, being both under-levered and

generating significant excess cash flows

that could not be profitably reinvested

into the business.

Step 2: Understand whether

Willow was undervalued or

overvalued in the market by examining

investors’ expectations from growth,

margins, investments and

other financial measures, in order to

define the options Willow could

exercise with its excess cash.

Step 3: Develop a financial strategy

to be proposed to the Board for

approval, ensuring that Willow’s

operations are sufficiently funded, that

financial balance is achieved, and that its

growing cash reserve is deployed

appropriately.

Step 1: Establish an Appropriate Capital Structure

Capital structure is often viewed as a

minefield of finance theory. Because of

this, many executives default to the status

quo, which, given changing circumstances

over time, rarely results in full value

creation.

• Peer group analysis – Peers’ current

capital structures and trends are analyzed

for insights into operating characteristics

that might indicate the ability to support

more or less debt.

• Bond rating analysis – The debt

capacity within given debt ratings is

assessed.

Establishing base-case and downside

scenario cash flows changes this

exercise from a theoretical discussion

to an intuitive one because it permits

the inclusion of risks, management

preferences, and cash flows into the

decision.

To understand the magnitude and

volatility of cash available for debt service,

the first step is to build a base-case cash

flow forecast for the next three to five

years. In Willow’s case, a year-four base-

case forecast was used (see Figure A on

next page).

Collaborating with management, a

number of key risks were identified

and quantified to develop a series of

downside cash flow scenarios. In each

scenario, decisions were made about the

level of capital investment that would be

made and whether the dividend should

be changed in order to work from a

realistic set of forecasts. Willow decided

that, under all but the most severe

downside scenarios, it would seek to

maintain at least 80% of its base-case

capital expenditures. Under no downside

scenario would it increase dividends.

An important key to solving the capital

structure puzzle is remembering that equity

funds (even for private companies) are

not free – in fact, they are very expensive.

While there is not a contractual obligation

to pay shareholders in the same manner

as there is for debt holders, there is a very

real opportunity cost inherent in equity

funds. The cost of equity is high because

shareholders bear the systematic risks of

being in a particular industry and will

suffer the most in a bankruptcy.

In comparison, debt financing is less costly

because, being subject to contractual

obligations – paying interest and repaying

principal – debt holders exchange more

certainty for a lower expected yield.

Additionally, debt is in a preferred position

in a bankruptcy and is tax-deductible,

further reducing its cost to the company.

While this favors using leverage, doing so

increases financial risk, the cost of debt,

and the cost of equity. How do these and

other factors interact to determine

an appropriate capital structure for

a company?

At Willow, we relied on three methodologies

to shape our recommendations on the

appropriate capital structure:

• Downside cash flow scenario

modeling – A capital structure is

derived from a set of downside cash

flow scenario forecasts. By definition,

this yields a capital structure that can

withstand the shocks of the downside

scenarios.

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With the downside cash flow scenarios

quantified, the next steps were to:

• Identify repayment terms for debt that

were realistic in a downside scenario.

It was agreed to use repayment of 50%

of the initial debt outstanding within

five years, reflecting the expectations

of Willow’s bankers.

• Value the potential for making acquisi-

tions and keeping some “dry powder.”

• Discuss with management the safety

margin that would appropriately

balance shareholder value with the

risks in the business. Given the steady

nature of the industry, management

chose to use 75% of the downside

cash flows to support its debt

(separate from seasonal needs).

• Calculate the amount of debt that

met the cash flow constraints and

made full utilization of the interest

tax shield. The results of the analysis

suggested that Willow should target a

capital structure with $762M of debt,

which added $117M more debt to

Willow’s existing capital structure. As a

consequence, Willow now had $117M

of additional capital to manage.

Analysis of the peer group proved not

to be insightful, as most meaningful

competitors continued to struggle with

overleveraged balance sheets as a result

of past acquisitions. Synthetic bond rating

analysis, on the other hand, was instructive

in outlining the debt levels at which

Willow’s debt rating might be watch-listed

and possibly downgraded. The $762M

target for debt fell within those levels,

which precluded, in this case, the debate

over whether to accept a lower debt

rating in exchange for the benefits of

higher debt levels.

In discussions with bankers and rating

agencies, L.E.K. also identified additional

debt capacity that could be borrowed,

should it be required for unexpected

investments. Willow’s management

decided that, while not optimal over a

long period of time, it would be accept-

able to borrow an additional $300M of

debt for the right investment. This did not

include the cash flow contribution from

an acquisition, which could potentially

support additional debt as well.

Step 2: Understand Whether Willow Is Undervalued or Overvalued in the Market

For share repurchases to be a viable

option, it was important to understand

whether the company’s stock price was

appropriately valued to avoid repurchasing

overvalued stock. To make that deter-

mination, the performance expectations

embedded in Willow’s stock price were

quantified and compared with manage-

ment’s forecasts. Through research of

investment reports, interviews with sell-side

analysts, and discussions with institutional

investors that held Willow’s stock or that

of its peers, a consensus forecast of inves-

tors’ expected value-driver performance

was created that explained Willow’s

$12.50 stock price at the time.2

By comparing investors’ expectations of

performance of a company’s value drivers –

sales growth, operating profit margins,

cash tax rate, and incremental fixed and

working capital investment – to man-

agement’s expectations, it is possible to

pinpoint the areas where they differ and

investigate how they can be addressed.

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The key difference between investors’

expectations and those embedded in

management’s forecast was the operat-

ing profit margins. Willow’s management

maintained a strong belief that the recent

changes it had made to reduce costs and

gain efficiencies would add noticeably

to operating profit margins. In addition,

the aggressive pricing strategies applied

by competitors seemed to have abated

(although this formed the basis for one

important downside cash flow scenario).

A discounted cash flow valuation of

management’s base-case strategic plan

yielded a value of approximately $15.00

per share for Willow, indicating the stock

was undervalued by 20%. Scenario

analysis, where different outcomes for the

business are captured in the value drivers,

was conducted with particular attention

paid to the impact of growth, pricing

and efficiencies on the operating profit

margin. This analysis identified the range

of undervaluation to be between 15%

and 25%.

L.E.K. also gathered commentary from in-

vestors indicating that they were pleased

with the fiscal discipline that Willow’s

management had demonstrated. As a

result, they expected Willow either to

find acquisition opportunities or to begin

returning cash to shareholders.

In summary, the conclusions from the

market expectations analysis were that

Willow was undervalued by up to 25%

and that investors supported a gradual

realignment of the firm’s financial strategy

to reflect its continued strong cash flows.

Step 3: Develop a Financial Strategy

The scenarios developed in the capital

structure phase served as the basis for

quantifying the amount of excess cash

Willow expected to generate from operations.

Excess cash is defined as:

Net Income + Depreciation & Amortization + Difference Between Book Tax and Cash Tax – Incremental Working Capital – Capital Expenditures – Acquisitions – Dividends + Proceeds from Exercise of Options

= Excess Cash

This definition incorporates not only oper-

ating and finance expenses (in net income),

but also includes expected outlays for

capital expenditures and acquisitions.

Excess cash is money for which Willow

currently had no immediate use. Manage-

ment’s base-case forecast indicated that

Willow would generate $489M in excess

cash over the next four years. With the

addition of $117M in new debt, Willow

expected to have $606M in excess cash

to dispense over the next four years (see

Figure B below).

Senior management recommended to

the board that Willow return a significant

portion of the excess cash to shareholders.

To help decide the exact amount and the

manner in which it should be done, L.E.K.

and Willow’s management created a

financial strategy framework that defined

the elements of the company’s sources and

uses of cash. The framework illustrated

how those elements could change over

time – but remain balanced – as the com-

pany evolved (see Figure C on next page).

Preferably, the first use of cash from

operations is to invest in capital expendi-

tures and acquisitions. In Willow’s case,

however, the investment opportunities

possible at the time could not absorb

the available cash. Thus, the other options

for the monies were to return it to share-

holders through various mechanisms such

as dividends or share repurchases, repay

debt, or accumulate the cash on the

balance sheet.

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Balancing Willow’s Sources & Uses of Cash

Cash Sources

Cash Balances

Willow had $92M in cash balances. An

analysis of Willow’s seasonal needs and

cash collection cycle determined that $74M

was a sufficient amount to maintain, leaving

$18M as excess. The board’s debate about

this amount centered on the need to keep

“dry powder” in the event of an adverse

event or an acquisition opportunity. However,

there is a cost to keeping cash on hand.

As with any other asset the company em-

ploys, cash must earn a return for share-

holders. A simple measure is to multiply

the excess cash by the cost of capital

($18M x 9% = $1.6M for Willow).This

annual “carrying cost,” and Willow’s

ready access to debt capital, drove consensus

of the required cash balances to $74M.

Operating Cash Flow

As shown above in the excess cash flow

analysis, which incorporates capital ex-

penditures and acquisitions, Willow was

expected to generate more than $489M

in excess cash over the next four years.

New Debt

From the capital structure phase,

L.E.K. determined that Willow should

borrow an additional $117M to move

toward an appropriate capital structure.

This added to the amount of excess cash

destined for distribution.

New Equity

Given Willow’s undervaluation, it was

deemed the wrong time to issue new

equity. However, at some point in the

future, an issuance of equity could be an

appropriate mechanism to balance Willow’s

sources and uses of cash. Presumably,

that point would occur when Willow is

overleveraged, overvalued, in need of cash

unavailable from other sources, or some

combination of the above.

Cash Uses

Cash Balances

One option for employing Willow’s incoming

cash flow was to keep accumulating cash on

the balance sheet. However, accumulating

an additional $489M over four years was

clearly excessive. Once management and

the board assessed the carrying cost of un-

needed cash, they decided to return the cash

to shareholders if it could not be invested at

attractive returns in the business.

Repay Debt

It seems natural that, if a company is cash

rich, it should free itself from the burdens

of debt. However, as the capital structure

analysis demonstrated, the opportunity

cost of equity capital should instead lead

to increasing Willow’s debt levels to better

balance the benefits of leverage with its

costs.

The board agreed that Willow should

make use of this low-cost form of financ-

ing, while still maintaining sufficient

access to the debt markets to finance an

unexpected acquisition that could create

a competitive advantage for the company.

Share Repurchase

Another option was to initiate a share

repurchase program and establish it as the

main instrument for distributing cash to

shareholders. The key reasons were that a

share repurchase program:

• Creates value for remaining share

holders if the stock is undervalued.

• Signals to the market that the stock is

undervalued, helping to raise the stock

price closer to management’s valuation.

• Returns cash to the shareholders who

want to sell their stock, thereby not

imposing a possible taxable event on

those who do not want one, as would

be the case with a dividend.

• Provides flexibility to distribute cash

as fits the company’s circumstances.

• Can return larger amounts of cash

to shareholders than an increase in

regular dividends.

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Repurchasing shares also shows a contin-

uation of management’s fiscal discipline.

There was little concern among investors

that Willow would be perceived negatively

if it openly acknowledged, through a re-

purchase of shares, that attractive acquisi-

tions or investments were not available.

It was understood that there were few

acquisition targets and that their prices

likely made them value destroying. Hence,

returning cash to shareholders was seen

as a sign of strong fiscal discipline.

While Willow believed it was undervalued

in the market, it wanted to approach

share repurchases cautiously. This, togeth-

er with the fact that it felt its shares were

potentially only mildly (as low as 15%)

undervalued and the amount of shares it

sought to repurchase was relatively small,

led them to favor an open-market repur-

chase program. One of three approaches

to repurchasing shares, an open-market

program permits the company to buy

back shares without a premium (as it

must with the two other methodologies)

when, if, and to the degree it chooses,

within established boundaries.

The magnitude of the repurchase pro-

gram was largely defined by the capital

structure and excess cash flow analyses.

However, to determine repurchase

amounts for the future, L.E.K. created

a mechanism to make explicit the key

considerations (see Figure D below).

This framework allowed management

and the board to discuss the amount of

excess cash that could be returned to

shareholders, specific management issues

to consider, investor considerations and

market conditions, all of which served to

help decision makers reach consensus on

the size of the repurchase program.

Regular Dividend.

Dividends communicate a strong, con-

tinuing commitment to return cash to

shareholders and indicate the company’s

comfort level with its ability to gener-

ate sufficient cash to do so in the future.

Willow had initiated a nominal dividend

two years earlier but had not planned

on it being a regular element of return-

ing cash to shareholders. However, new

changes in the tax treatment of dividends

had removed significant tax disadvantage

compared to capital gains.3

In addition, investors have come to appre-

ciate and to a certain degree expect

cash-rich companies to issue dividends.

A nominal dividend is generally not

sufficient for a company such as Willow.

The decision was made to increase the

dividend moderately to yield 1%, which

was approximately half the S&P average

dividend yield at the time but signaled

a step in the right direction.

Special Dividend.

A special dividend can be considered a

pressure relief valve when other avenues for

utilizing cash are deemed inappropriate. It

is used by companies that have significant

excess cash (after investments and acquisi-

tions) and overvalued stock, and who do

not want or need to repay debt or increase

the regular dividend. In those circumstanc-

es, repurchasing shares would destroy

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value, so issuing a special dividend would

relieve the pressure of cash accumulating

on the balance sheet. Since Willow’s stock

was undervalued, a special dividend was

not considered.

Implementation and Results.

Ultimately, Willow decided to increase

its financial leverage by $117M over

an 18-month period, leave its dividend

payout untouched, and undertake a

multi-year open-market share repurchase

program, starting with an amount up

to $75M in the first year, to be revised

annually. As expected, the announcement

was well received by investors and created

a small but important abnormal increase

in the value of the stock during the week

following the announcement. Willow

went on to repurchase the full amount

of stock it had targeted and, within nine

months, the board agreed to raise the

dividend to a yield of 1% with the inten-

tion of gradually increasing it to 2%.

The following year, Willow increased its

share repurchase program because excess

cash flows exceeded original estimates

and, with experience, management and

the board gained a level of comfort that

their financial strategy was appropriate for

the company’s situation. Willow’s stock

continues to rise, outperforming both the

S&P500 and an index of its peers.

The company’s performance targets also

continue to rise. When L.E.K. values man-

agement’s internal plans on a semi-annual

basis, we note that, while the value gap

is still present, it is shrinking. Clearly,

Willow’s strong financial results, its

self-declared focus on cash flow and its

financial strategy have led investors to

re-evaluate their expectations of future

sufficient time for the company and inves-

tors to digest the significance of changes.

It is rare that all cards need to be played

at one time. Directionally correct moves

toward an appropriate target, combined

with an approach that avoids the costly

mistakes of hoarding unneeded cash, not

utilizing debt capacity, etc., can create sig-

nificant shareholder value.

Fourth, communicating both internally

within the company and externally to in-

vestors can help refine a financial strategy

and possibly avoid costly missteps. Creat-

ing a common framework within which

Willow’s board could discuss financial

strategy in a holistic manner proved to be

constructive and avoided endless debates.

Shareholders have benefited from Willow’s

realignment of its financial strategy

through an increasing share price, having

an appropriate amount of leverage and

exercising ongoing fiscal discipline. These

benefits continue to add significantly to

the firm’s shareholder returns and to the

overall health of the organization.

While financial strategy is just part of a

broad arsenal of tools available to enhance

shareholder value, it is an important one

because it provides a number of levers

that can be fine-tuned on a regular basis.

Its effectiveness relies on management

teams’ and boards’ willingness to evaluate

and adjust those levers as frequently as

they do those of their operating strategies.

1.“Willow, Inc.,”is a disguised corporation. All values have been disguised.

performance to be more in line with

those of management. The existence of

a value gap indicates that open-market

share repurchases continue to be an

appropriate tool for Willow to manage

its excess cash position, especially as it

provides the flexibility to act in the event

that a significant investment opportunity

is revealed.

Applying the Lessons

Willow’s case, while specific to its

conditions and needs, provides important

lessons for companies that are looking to

align their financial strategies with their

operations in the ongoing effort to

maximize shareholder value.

First, boards of directors and management

that are sharply focused on maximizing

the value of the firm will recognize the

importance of reviewing and adjusting

their financial strategy just as rigorously

and frequently as their operating strategy.

The latter supports the former, but many

companies stop after having addressed

only their operating strategies, leaving

on the table the opportunity to create

even more value.

Second, the perceived shroud of complexity

surrounding financial strategy can be

lifted by analysis that is well grounded

in finance theory but made intuitive

to decision makers. Without sufficient

financial data, relevant frameworks, and

effective decision-making processes in

place, critical financial decisions can be

misguided and/or next to impossible

to execute.

Third, a measured and deliberate approach

to changing financial policy can provide

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L.E.K. Consulting is a global management consulting firm that uses deep industry expertise and analytical rigor to help clients solve their most critical business problems. Founded more than 25 years ago, L.E.K. employs more than 900 professionals in 20 offices across Europe, the Americas and Asia-Pacific. L.E.K. advises and supports global companies that are leaders in their industries – including the largest private and public sector organizations, private equity firms and emerging entrepreneurial businesses. L.E.K. helps business leaders consistently make better decisions, deliver improved business performance and create greater shareholder returns. For more information, go to www.lek.com.

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